Two Thumbs Up : An Excel-Based 'Movie' to Teach Term Structure Dynamics

SUBJECT AREAS: Term structure of interest rates; Dynamics; Treasury bills; Treasure securities; Business cycle. CASE SETTING: 1970 to present, U.S. risk-free, zero-coupon yield curves. For twenty years, the modern theory of the term structure of interest rates has been based on dynamic models of how interest rates and other relevant factors evolve randomly over time. Yet most undergraduate and M.B.A. textbooks that cover the term structure say nothing about its dynamic features. The only exception to this rule is a handful of specialized textbooks intended for advanced courses in fixed-income securities or derivative securities. The insurmountable obstacle to covering term structure dynamics has always been the rigorous demands of continuous time mathematics. We offer a new approach. We explain simple techniques by which Microsoft Excel can be used to construct a #movie# of the term structure. This movie dramatically illustrates the important dynamic features of the term structure, including: 1. short rates are more volatile than long rates, 2. occasional sharp reactions to government intervention, 3. volatility is correlated with the level (i.e., volatility is lower when the level is lower), and 4. reversal in the slope of the yield curve is a noisy predictor of the business cycle. We also make available the finished product to download at a Web address: lt;a href=www.bus.indiana.edu/finweb/holden.htmgt;www.bus.indiana.edu/finweb/holden.htmlt;/agt; The raw material for this movie is a historical term structure database of monthly U.S. yield curves over the past 26 years. With a standard computer / projection setup, the instructor can show this movie in class. After seeing the visual history of the yield curve, students will immediately recognize the #stylized facts# about the term structure